The Coming Train Wreck

by Bruce Judson on June 18th, 2012

The U.S. housing market and any economic recovery are confronting a brick wall, and no one is discussing it. Like a speeding train, the housing market and our economy are heading over a cliff with no bridge. Yet, no one in Washington wants to discuss this very real and approaching danger.

Recently, Salon ran an article on the conflicting, confusing, and ineffective nature of housing policy to date. The article traced the conflicting narratives and debate associated with principal reduction and the Obama Administration’s efforts in this arena.

Andrew Leonard, the author of the article, interviewed me as he was trying to sort out the different issues, and the article correctly states, that I believe there is a “night-mare scenario” in which Congress fails to extend essential legislation before it expires at the end of this year. If Congress does not act, we will almost inevitably see a further collapse in the housing market, with a ripple effect that has the potential to destroy vital consumer confidence, stop any economic recovery, or even cause an economic catastrophe.

There’s even a nightmare scenario in which the entire fight over principal reduction becomes, in Judson’s words, “irrelevant.”

That’s because, says Judson, tax law historically treats principal reduction as income to the homeowner who gets it. In other words, if you have a $300,000 mortgage on a house that is now only worth $200,000, and your bank gives you a $100,000 break to bring the mortgage and the home value in line with each other, the IRS will consider that $100,000 break taxable income.

Congress recognized this obvious insanity in 2007 and passed a provision that gave homeowners a waiver from that liability, but the waiver will expire on Jan. 1. Not only would the change in tax law mean that getting a principal reduction would make no sense for a beleaguered homeowner, but it would also destroy the market for “short sales” — in which banks allow homeowners to get out of their mortgage by selling their property for less than the mortgage is worth. Judson believes some 30 percent of home sales are currently short sales. Knock the legs out of that market, and you’re asking for serious trouble.

“If we hit a train-wreck on Jan. 1,” says Judson, “it will take the housing market and any economic recovery down with it.”

At present there seems to be almost no discussion of extending the income tax exclusion, either emanating from the Executive Branch of from Congress.

Let’s look the current housing market. In January of 2012, short sales comprised 24% of all home sales, as compared to 20% for bank foreclosure sales. Moreover, there’s a seemingly uniform belief that the number of short sales as a percentage of total home sales has been rising since January, and will continue to rise. So, any housing recovery or price stabilization we are witnessing reflects, in large measure, the rise of short sales. My best estimate is that right now short sales do, in fact, represent about 30% of all home sales.

How many of the recent short sales would have taken take place if the homeowner selling were then forced to pay income tax on the debt forgiven? To my knowledge, no one has analyzed the size of the tax debts that would be incurred. But, here’s my hypothesis: In this era of high unemployment, little if any wage growth, and a reduction in the median American family’s net worth to 1992 levels, the answer is not a lot.

Reportedly, Republicans believe that extending the tax exclusion will cost the government $2.7 billion, and oppose it, in large part, based on this estimated cost. This makes no sense.
First, no one has ever released the source for this estimate. It is almost certainly based on an assumption that short sales continue after the exemption is removed, and the government collects the income tax. As discussed below, this reasoning is nothing short of ridiculous.

Second, our nation has spent hundreds of billions of dollars to prevent a collapse of the economy. The idea that we will put at risk the health of the entire housing market, and its spill-over effects on consumer confidence and the economic recovery, to save $2.7 billion is ludicrous.

Does any rational person believe that homeowners who need principal reduction in order to maintain their mortgages will be able to afford the income tax on an additional $100,000 (if that’s the amount forgiven)? Instead, it seems likely these homeowners will do everything possible to tough it out, and start to refuse principal reductions offered by the government or the banks. Suffering American homeowners will be in the impossible situation of refusing assistance because of the short term cost (i.e. the income tax imposed) on this assistance: The one situation every American wants to avoid is a large, unpaid bill from the IRS.

Any housing recovery is almost unquestionably dependent on the continued growth of short sales. If Congress fails to act, short sales will almost certainly return to an anemic level. We are playing fire, and the chances of serious burns are not slim.